Regime Changes in Stock Returns

Abstract:     
This paper models stock returns as a function of three components: a constant expected return, the impact of the mechanism for executing trades, and a rational expectations error. We examine changes in these parameters using Goldfeld and Quandt's (1976) deterministic switching based on time. This method not only allows us to learn if and when the regression structure changes, but also provides a measure of the speed of transition from one regime to the other. We find that, regardless of the sample period, all regime shifts are due to changes in the estimated variance of the error. This is true even if the ex post return on the stock portfolio or the estimated rate of compensation for financing costs changes substantially. In addition, these structural shifts occur during substantial changes in the business environment, driven by important political decisions. We interpret these findings as suggesting that government policy strongly affects the volatility of the stock market.

Keywords: regime changes, stock returns, switching regression, volatility

JEL Classification: G1, G2, N2, H8

Accepted Paper Series